What Is Hedge Ratio?
The hedge ratio identifies the exact point for an index at which dynamic delta hedging will take place.
Dynamic hedging is defined as “delta hedging of a non-linear position with linear instruments like spot positions, futures or forwards. The deltas of the non-linear position and linear hedge position offset, yielding a zero delta overall. However, as the underlier’s value moves up or down, the delta of the non-linear position changes while that of the linear hedge does not. The deltas no longer offset, so the linear hedge has to be adjusted (increased or decreased) to restore the delta hedge. This continual adjusting of the linear position to maintain a delta hedge is called dynamic hedging”.
The Hedge Ratio simply does it for the entire market, or index.
So, in short, the Hedge Ratio identifies, on an index, in advance, where dynamic hedging will take place, and grades the degree of dynamic hedging (futures buying or selling) to expect.
Starting with the NZ (Neutral Zone) where there is no Hedge Ratio, then up to YI and Y2, both minimal amounts and as such the most sensitive and therefore very fluid and so a good indication of whether the ratios are building or receding.
On the continuing exponential scale we then get the R ratio, the degrees of which are numbered in ascending magnitude 1, 2 and 3.
The next level is DR which is on its own as it has historically proved to be a significant enough level to turn markets around.
Above this is the B ratio level where markets can venture but in reality they shouldn’t.